You need more employees.
Let me tell you about the best kind of employees out there. The best employees never take a bathroom or smoke break. They work just as hard at the end of the day as at the beginning. In fact, they work 24 hours a day, 7 days a week, and 365 days a year. They never get sick, or hurt, or take a vacation. They require no benefits, or worker's comp insurance, or even payroll taxes. Who are these employees? These are the dollars you earned but did not spend, i.e. your investments.
The Value of Your Investment “Employees”
Any given one of these “employees” might not be particularly profitable. They might only be good for a nickel, or perhaps, if you're lucky, a dime each year. But when you have 500,000 of them or better yet 2,000,000 of them, those nickels and dimes really add up. At a dime apiece, those two million employees are the equivalent of a physician income.
Tax Benefits of Your Investment “Employees”
One of the best parts of these special “employees” is that they face a much lower tax burden than that physician. For example, that physician earning $200,000 per year not only will be paying taxes at a Federal marginal rate as high as 32% and a state marginal rate as high as 9%, but will also be paying payroll taxes.
Your “employee dollars,” however, may be paying as little as 15% at qualified dividend or long term capital gains tax rates. Perhaps less if sheltered by depreciation. Perhaps nothing if those “employees” are working in a tax-free account such as a Roth IRA. And no matter where they are located, none of them will be paying any payroll taxes at all.
The Cash Flow Quadrant
This seems like a good time to bring up Robert Kiyosaki's famous Cash Flow Quadrant. Now, no matter what you may think of Kiyosaki (and admittedly my opinion isn't all that high) and his (probably) fake Rich Dad, this is a useful concept to understand. Here it is:
The Employee
Starting on the upper left is the “Employee” Box. This beats not being in any box at all, because at least you have an income. The problem with being an employee is one which many physicians can appreciate. Your income tends to be VERY highly taxed and you have little control over how you do your job, whether or not you are fired, your tax burden, and your benefits package.
The Self-Employed
The “Self-Employed” box has numerous benefits over the “Employee” box. When you move into this box, you get to keep the profit you generate. Remember no employee is ever paid what he is worth, if he were, there would be no point to hiring him if he costs just as much profit as he generates.
The Self-Employed can't be fired (except by his clients!) He gets to pick (and pay for) his own benefits package, but has a great deal more control over his tax burden, with more write-offs and better retirement plans. You own your job, but you still have to go to work.
The Business Owner
The “Business Owner” box represents an improvement over the “Self-Employed” box in that the business makes money even when the owner isn't there. Sure, there may be some great effort in getting the business started, and maybe even some invested capital, but a certain amount of money coming out of the business is passive. You own the job AND don't have to go to work every day.
A C Corporation business structure also provides a few tax benefits that the typical self-employed business structures (sole proprietors, LLCs, S corps) do not. Essentially, when you own a business, you get to pay all your expenses first then pay taxes, as opposed to the employee situation, where you pay taxes then pay all your expenses. A subtle difference, but it adds up quickly, especially if you're willing to be creative and aggressive on your taxes.
The Investor
Kiyosaki's “Investor” box is his ideal. This situation is that which I began this post with, where you have hundreds of thousands of little “employees” running around earning nickels and dimes on their own each year. You don't have to go to work at all!
There are also lots of great tax benefits including retirement accounts, depreciation with real estate investments, tax-loss harvesting, the step-up in basis at death, the donation of appreciated shares to charity, and lower tax rates. But the best part is that it is all (mostly) passive income, meaning you don't have to work for it. True capitalism if you will.
How to Convert Earned Income to Passive Income
The way to get wealthy is to take your earned (and thus highly taxed) income and convert it to investments as quickly as possible. Essentially, you're moving your money from the Employee and Self-Employed box to the Business Owner and Investments box.
How do you do that? First, you must carve out a significant portion of your income with which to build wealth (I generally recommend 20% for docs.) Then you must invest it in a reasonable manner. Then leave it alone and let it work. Before long, you may find that you have hundreds of thousands of employees providing you more income than you can generate on your own, no matter how hard you work.
What do you think? What do you do for passive income? How have you found success moving from the “employee” box to the others? Comment below!
love this analogy. it motivates me to dump at least half my paycheck into savings before considering what to do with the rest. i’m convinced that converting earned income into invested assets is critical in the first few years of practice. at some point, the power of compounding will take over. i want to get to that point at soon as possible.
i wonder how many years of savings it has taken most readers before first seeing the effects of compounding?
Compounding technically starts from the very beginning. But even 12+ years into my investing career, the vast majority of my stash still represents brute force savings. Part of that, however, is that my income and contributions have steadily gone up over that period.
Here is an example. I saved a huge chunk of my paycheck every year right out of residency. After 6 years I have amassed over $1 million. Today I have 3 options.
I can retire today and live a modest lifestyle.
I can semi retire today and not add a single penny to retirement and let compound interest take me the rest of the way.
I can increase my lifestyle not adding a single penny and let compound interest do its job.
compound interest is working for me today. Even though the markets this year have not behaved as hoped.
Great post! Do you recommend 20% savings for docs as pretax or post tax savings? Trying to have a goal in mind and that can make a big difference. Thanks!
20% is great. 50% is even better. Do that for 5-7 years and you will be set for the rest of your career.
20% post tax at the bare minimum. 20% pretax is preferred.l considering a big junk of your savings will be pulled pretax.
WCI usually means 20% of your gross income as savings. So that means pre-tax. That is a great starting point. If you have more room and can save more, even better. Like Alex said, if you can save 50% of your income for 5-7 years, you can reach financial independence faster and can have the option to work or not. That’s a nice place to be.
Right, 20% of gross. That’s very doable if you start with your first paycheck out of residency and never get used to that money.
A common comment is “the first million is the hardest.” It is very true, it took me 37 years to get to the first million, 3 years later, it’s up to $3 million. Early, aggressive saving is so, so important. “Live like a resident for 5 years,” is the best advice anyone can give you. The ball is rolling along on its own now and continues to grow rapidly once there is some critical mass to it. We are now living a very comfortable life with vacations, house, and cars. No retirement in sight for me, but I don’t worry about the loss of income when taking days off. My little minions are working their tails off–harder than me! I’m still adding more to the pot, but the pot is now adding more to itself each year than what I can add to it…it’s taken on a life of itself! 🙂
Wow! This is impressive. 37 years to $1 million and 3 years to get to $3 million from $1 million? This is great stuff and inspiring as well to some of us that are starting on this journey. Congratulations on your success.
That is amazing. I’m 33 and I aspire to do that.
The older and wiser (??) 🙂 I get the more I view our today’s expenditures and saving/investments as 2 types of insurance: the first one is for rather premature death/disability if don’t get to live long enough to enjoy the fruits of your investments, the second one is for the opposite type of event (which is more likely for most people)- when you do get to grow old and really wise…
The other thing is that I wish people would comment on the notion of compounding outside of simple saving account- do we know how it works within, say, a simple 70/30 portfolio? That is, what is the intrinsic rate of compounding without counting cap. appreciation over the last, say, 20 yrs? ( I guess, only dividends would be counted?)
It’s not clear what you’re asking. Are you asking what the return of a 70/30 portfolio has been over the last 20 years? Vanguard’s Life Strategy Growth is 80/20 and has returns since inception 21 years ago of 8% per year. Or are you asking what the “income” from that portfolio is. Currently it yields 2.19%. Compounding money at 2% takes 35 years to double your money. Compounding at 8% takes 9 years to double your money.
Hope that’s helpful.
Nice post! Love the diagram and I feel that I do a bit of everything… Mainly W2 physician (employee) but with consulting business on the side (self employed). This is mainly speaking, legal work or advisory boards. Rental business with 4 properties which may technically be an investment but I employ my wife and kids with all of the above… Someone has to do the banking and accounting, plus helpful for tax purposes (business owner). 20-30% of everything going into investments (Investor). So after a decade or so working my butt off through med, residency, fellowship with virtually no pay.. our net worth 4-5 yrs post fellowship is pretty darn close or past the million dollar mark but I think I will feel it more I see the actual number!
Did you have any student loans that were paid off in this 4-5 year stent while you were saving?
Yes $100k myself and my wife had about $90k… She’s also a physician that worked heavily while I was in fellowship. And she also participated in those underserved programs that paid something like $25k annually. Now she only works one day a week part time…
This is one of my favorite articles ever. Great perspective I’d never considered and the comments are inspiring, particularly @Steve and @ST. I will be using this analogy in the future.